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FRM Part II · FRM Exam Part II · Madoff: A Riot of Red Flags

During due diligence on a $2 billion hedge fund, an investor discovers that its auditor is a three-person firm that audits no other funds of comparable size. Which is the most appropriate risk-management conclusion?

This is a red flag. A tiny audit firm lacks the capacity and expertise to verify a large, complex fund, so even a clean opinion gives little assurance. Due diligence should escalate the concern and seek a credible independent auditor before any investment.

  1. AAcceptable, provided the audit opinion is unqualified, since the opinion is what matters
  2. BAcceptable, because small auditors are more independent and less conflicted with large managers
  3. CA red flag, because the auditor's capacity and expertise are doubtful for the fund's size and complexity, so it should be escalated before investingCorrect
  4. DIrrelevant, because auditor quality affects only tax reporting and not operational risk

Explanation

An audit gives assurance only if the auditor has the resources, experience and independence to test a large, complex fund. A tiny firm cannot plausibly do so, as in Madoff's case. An unqualified opinion from an incapable auditor offers little comfort.

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